Keep business expenses separate

Many entrepreneurs spend a lot of their own money on their business, which results in mingling personal and business financial assets. Unless they separate their finances and put proper controls in place, especially for the personal use of corporate assets, they can suffer adverse tax consequences.

The most common mingling situations involve the shareholder using something owned by the corporation or the corporation buying something that’s primarily for the private use of the shareholder. The issue usually arises once the business has become successful and has strong cash flow, and the shareholder turns to the corporation as a ready source of funds to satisfy a purchasing desire.

These purchases typically include vacation properties, aircraft, a yacht or artwork. Sometimes, the shareholder considers the asset has a business purpose, in whole or in part. Sometimes this is accurate, but often it’s really just personal.

Generally, when a shareholder receives a benefit from the corporation, that benefit is considered taxable; and that amount must be included in the shareholder’s income. This rule is designed to ensure the appropriate tax is paid on corporate distributions, including a “constructive distribution” if there has been personal use of corporate property.

What the Court Says

Personal use of corporate assets has been the subject of many court cases. They usually result in a shareholder benefit being assessed; and this is especially true when the assets are luxury items. The main issue in these cases tends not to be the existence of a shareholder benefit, but rather the valuation of that benefit. In situations where the asset was found to have also been used for business purposes, the shareholder benefit was limited to the commercial value of the shareholder’s personal use.

In one case a corporation owned a yacht that was frequently used to promote its business and to help secure contracts. The shareholder’s personal use of the yacht was found to be incidental to the business activity and therefore the allocation of the operating costs to the shareholder was modest. Similarly, where a house owned by a corporation was used extensively for business purposes, and the shareholder who lived in the house paid a fair market value rent for it, the court concluded the rent represented appropriate payment for the benefit received for the personal use of the house.

A more common scenario involves a substantial assessment. One shareholder had the exclusive use of a house owned by the corporation for as long as he wanted, and he had had it built to his personal specifications. In that case, the fair market value of the rent was not considered sufficient for determining the value of the shareholder benefit, because the corporation’s resources could have been applied to some other purpose to generate income. The court assessed the shareholder for a benefit that included an amount for the return on the corporation’s equity in the house. The court did, however, allow for the reduction to the shareholder benefit, to offset the cost of the interest-free loan the shareholder had provided to the corporation to build the house.

It’s important to be aware of the various rules and policies applicable to specific assets, such as aircraft. These rules influence the calculation of the taxable benefit.

Canadian tax law denies the deduction of outlays unless they have been incurred for an income-earning purpose. Is there a reasonable expectation of profit from the use of each asset purchased by the corporate owner? If recreational assets are used by a shareholder, and the direct business purpose is marginal, it is questionable whether an income-earning purpose exists. For these assets, in addition to a shareholder benefit, there’s a risk the company’s tax deduction for the expenses associated with the asset will be denied.

Tax authorities and the courts will inevitably conclude assets used by the shareholder are not for income-earning purposes if the company has consistent losses and had been inadequately capitalized with virtually no capacity to generate a profit due to high interest costs. It is a problem if the taxpayer has no business plan, does not advertise or allows family and friends to use the asset at a below-market cost.

So, how can a business owner avoid these issues?

First and most importantly, shareholders shouldn’t hold assets that are strictly for personal use in a corporation. The shareholder should withdraw funds from the corporation, pay the applicable personal tax, and buy the asset personally. Otherwise, the shareholder will be deemed to have a taxable benefit and the corporation won’t be allowed to claim any associated deduction.

Second, where the asset is intended for a mixed personal-business use, it is critical to calculate the personal use element and ensure the shareholder compensates the corporation for the personal use portion of the cost. Further, analyze and substantiate the commercial purpose of the business portion of the use, which should be the primary purpose.

Finally, a luxury asset intended for commercial use should be carefully managed to avoid any suggestion of personal benefit. The tax authorities will approach these situations with a degree of skepticism, so the shareholder should act prudently in running the corporation and have a robust business plan to demonstrate commercial substance.

Heather Evans is Partner, Deloitte & Touche LLP in Toronto.